Financial performance through risk management: legal risks

Written on 8 Dec 2020

The second part of the series on risk mitigation for energy investors assesses ways that legal risk can be managed and avoided.

UK energy prices in 2020 dipped to their lowest levels in a decade, placing renewed pressure on energy investors and asset managers to look at how they approach threats to the financial performance of energy assets. Understanding legal risks and knowing how to manage them is one of the most effective ways to enhance the performance of these assets.

A recent Osborne Clarke webinar – part of a series that has also looked at legal obligations and protecting energy assets – considered how this can be achieved, looking at mitigating property costs, the risks of inaction, decommissioning security, exposure mitigation, contract management, asset optimisation, effective operations and maintenance (O&M), and good health and safety practices.

Mitigating property costs

Renewable energy assets are typically constructed and operated on leased land – and where there are leases there is the potential for disagreements between landlords and tenants. Two issues that may bring renewable tenants and landlords into conflict with potentially major hidden property costs are double-compounding rent reviews and decommissioning security.

The majority of renewable asset leases contain rent review provisions, whose purpose is to adjust the rent over time to keep pace with inflation and other changes in the value of property. Renewable leases tend to use index-linked rent review provisions, which are often linked to the retail price index.

These index-linked rent review provisions can be susceptible to a drafting error, leading to the inadvertent creation of a double-compounding rent review. If the rent review provision is applied literally then the landlord receives the same increases in inflation multiple times on a compounding basis, which sends the rent skyrocketing.

This may affect the value of the asset. For instance, if the landlord spots the provisions and requests the rent on the basis of a literal interpretation of the rent review provision there can be a huge rental liability. However, what if there is a lease that contains a double-compounding rent review provision and nothing is done about it?

Inaction risks

There is a risk that a solicitor on the other side of a refinance or disposal of the asset may notice the provision and advise the lender or purchaser that the rent review provision renders the asset valueless or unbankable. Furthermore, failure to pay would be a breach of the lease and, unless that lease is varied, this could put you in breach of the lending facility. It may also affect a director's reporting obligations.

However, in MonSolar IQ Ltd v Woden Park Ltd – one of OC's recent renewable energy cases – the courts showed that they are willing to correct mistakes in a lease that can be classified as absurd or irrational. Unless there is evidence that both parties always intended the rent to be reviewed on a double compounding basis, there is a good chance that the clause will be viewed as a drafting mistake. As a result of the decision in this case, tenants are in a stronger position to ask landlords to vary double compounding rent review clauses.

Decommissioning security

Many renewable energy leases contain an obligation on tenants to provide security for the cost of non-compliance with reinstatement obligations at the end of the lease, known as a decommissioning security. Often this will be a very simple provision where the tenant will be required to pay a fixed amount on a fixed day in a prescribed way. Some leases are not so simple, and require the amount of security payable to be agreed with the landlord or determined by an expert surveyor, with the security sum being calculated by reference to the tenant's obligations to restore the leased premises at the end of the lease.

The problem with these provisions is that the cost of reinstatement is not fixed, but is a variable sum that is not easy to identify and can change over time. This means that a tenant will need to establish the cost of reinstatement in order to determine its security liability. This will help tenants overcome a potentially expensive problem: landlords often see a tenant's reinstatement obligations as a way to get their land back in a better condition than when it was leased and will, therefore, seek inflated levels of security.

Some leases allow decommissioning security to be given in the form of a parent company guarantee, which is great for the tenants as they do not have to put up any capital. However, other leases state that the payments have to be provided through a bank bond or into an escrow account. That means that the tenant has to find the money to sit behind the bond or in the escrow account for 20 years plus. We understand that landlords have been demanding security at levels of £10,000- £30,000 per acre. Across a large solar farm this is a substantial sum; across a portfolio this could be a seriously debilitating.

A problem is that tenants can't avoid these obligations and failure to comply can put the tenant in breach of their leasehold obligations and could constitute an event of default under their loan facility. Tenants have no choice but to put themselves in this unenviable financial position.

Exposure mitigation

Given that this is an unavoidable financial obligation, what can tenants do to mitigate their exposure? They need to know their lease, especially the reinstatement, repair and security obligations. Without that knowledge tenants will be blindly entering into any negotiations with landlords regarding security.

It is important they know their site and undertake inspection to establish where the site has been damaged during construction or occupation and what has to be done to put this right at the end of the lease. They also need to know their costs. Instruct a contractor to provide a quote for you to comply with those legal obligations.

And they need to know their indemnities. They should check if they have any warranties or indemnities to claim against in the Energy Performance Certificate contract for damage caused during the construction phase. Doing all of this will put them in a good position to negotiate their security. As the review occurs on a five-yearly basis getting the first one right is good to set a precedent and hopefully make the rest more straightforward.

Contract management

Keeping on top of the suite of contracts across a portfolio can ensure that value is maximised and the assets are optimised. Getting it wrong can be costly and time consuming. There are areas where issues commonly arise: variation, subcontracting, assignment, and novation.

It is common for a contract to include a "variation" clause, often called a no oral modification (NOM) clause, which are a standard provision in the energy sector included as a boilerplate term at the back of a contract. They often provide that any variation will not be valid unless it is in writing and signed by all parties. Parties used to be able to agree that this clause could itself be varied, however, not since a Supreme Court ruling om 2018. Now, to vary a contract, its terms must be followed and properly documented. If there is a NOM clause, the formal procedure set out in the clause must be followed in order to validly vary the terms of your contract.

A party can subcontract an obligation under a contract unless it is expressly prohibited from doing so in the agreement, or if it can be shown that personal performance or specialised services were required. If you are the employer, you will likely want to keep control of the contract and only allow approved subcontractors on to your site. Importantly the contracting party is not released from its obligations. The main contractor remains liable regardless of whether they have subcontracted their work to another party.

This involves passing on the rights that are entitled under the contract, and is often done on a unilateral basis. Only the benefit of a contract can be assigned; obligations or burdens cannot be assigned. The assignee is entitled to the benefit of the contract and to bring proceedings against the other party in its own name. However, the assignor remains liable for the performance of the contract and remains the contractual party at the head of the chain.

A contract cannot be assigned, as it is a bundle of both benefits and burdens. A novation agreement has to be entered into to transfer an entire contract. The contract is extinguished and is replaced with another contract with a third party, which is taking up the rights and obligations that usually mirror the original contract. Usually, only important contracts are novated as consent has to be fought from all the parties involved and it can be an opportunity for parties to attempt to renegotiate the contract. One risk is that a contract is deemed as novated over time via conduct rather than in a written novation agreement. However, keeping on top of arrangements can help avoid contracts being novated by conduct.

Asset optimisation

Risks will arise around the points of interaction between different parts of any construction project –known as the "construction interface" – which will need to be considered even during the operational stage. However, as a project moves from the construction stage to post-completion and pre-final acceptance and to post-final acceptance – the passage of time reduces risks and problems become less likely, whether in terms of costs, financial viability, timings, or defects.

The construction phase is when things are most likely to go wrong, such as costs and the financial viability of the asset. By the time of completion of the work, the asset should be performing as intended. The post-completion and pre-final acceptance phase is a period of lower risk, when the asset will be operational and testing and commissioning undertaken. A specific risk at this phase is that testing occurs at the time(s) stated in the contract: slippage can cause issues around the validity of performance guarantees and entitlement to liquidated damages.

Final acceptance also needs to be properly managed: there should be no sign off unless you are entirely happy – this is the time for any outstanding issues to be resolved. The post-final acceptance period should have the lowest risk. If there is a problem here, it will likely involve defective plant and may be trickier to resolve.

Another factor to take into consideration is to understand the conditions at the plant. "Boots on the ground" and site surveys are vital for keeping a check on whether there are problems and the plant is safe, and to identify any future issues that might emerge and need to be addressed. Owners could build their O&M and upgrade regime around these findings and their industry knowledge and experience – for example, issues around different types of equipment. This enables an up-to-date centralised asset register, which allows for the owner, asset manager and O&M contractor to know what equipment is on site and the state it is in.

Effective O&M

There are three main aspects of effective O&M – getting the right scope, managing performance and mitigating risk – that can drive improvement and savings. The scope should be specific and detailed with sufficient technical input to specify the owner's practical requirements.

It is important to think ahead and detail in your specification what is required and expected. While there will be fall-back provisions in the contact – such as, services are required to be in accordance with good industry practice – specificity in the scope will avoid issues further down the line (including, for example, what constitutes good industry practice)."

Managing performance and the ability to report and monitor the performance of the asset is critical for the successful running of any asset. Owner's need to know the plant is operating as it should in order to generate the revenue required. Reporting needs to be regular and presented in a digestible way for the owner, with the ability to draw down on underlying data if needed. Timing is critical in order for appropriate mitigation to be deployed in case of an issue.

Good health and safety

Health and safety goes hand in hand with asset management. Sometimes they have competing objectives but it is important to keep them linked. Poor asset management can have an impact on health and safety and its risk control measures. Often health and safety issues are hidden from senior management until a significant incident occurs. Two-way and informed communication is essential, decision makers need to be able to identify trends. If senior management does not have visibility of what is going on, they cannot get on top of things before they escalate. Ignorance is rarely bliss.

Good health and safety management involves four stages: planning, doing, checking and acting. Planning needs to be proportionate to the risks. Doing requires an assessment of the risks and deciding on control measures. Checking performance involves investigating accidents and near misses, reviewing the performance and the data, and taking action and learning lessons.  Much of this can be dealt with via information flows, leadership and policies, monitoring, and the visibility of what is going.

Often there can be a concern that more involvement means more responsibility and more liability, especially when there it not proximity to the control of the risk on the ground. Good health and safety systems must be proportionate to the risk and your proximity and your level of control. Systems need to be realistic and practical and not overly onerous."